THE DAVID HUME INSTITUTE Executive Pay – a career perspective Brian G M Main June 2011 Hume Occasional Paper No. 89 The David Hume Institute 26 Forth Street Edinburgh EH1 3LH © The David Hume Institute 2011 ISBN 978-1-870482-91-2 Executive Pay – a career perspective June 2011 Brian G. M. Main Brian G. M. Main Professor of Business Economics University of Edinburgh Business School 29 Buccleuch Place Edinburgh EH8 9JS 44-(0)131-650-8360 [email protected] The author is grateful for research support under ESRC Grant RES-062-23-0904 About The Author Graduating with a physics degree from the University of St Andrews, Brian Main first worked for the United Kingdom Atomic Energy Authority before going on to study for an MBA at the University of California, Berkeley. After a short period as a manager with the Eli Lilly Corporation, he returned to Berkeley where he completed a PhD in Economics under the supervision of Professor George Akerlof and graduated Phi Beta Kappa. Appointed to a Lectureship in Economics at the University of Edinburgh in 1976 and promoted to Reader in 1983, he subsequently moved to the Chair of Economics at the University of St Andrews in 1987. He returned to Edinburgh as Professor of Economics in 1991, and moved to a Chair in Business Economics in 2002. Between 1995 and 2005, he served as Director of the David Hume Institute. He has been a Fellow of the Royal Society of Edinburgh since 1998. Initially working in the area of labour economics, his research centred on the distribution of unemployment and on the evaluation of manpower training programmes. More recently, he has focused on the economics of executive remuneration, examining executive reward both in the USA and in the UK. An important characteristic of much of this work has been its recognition of the effects of social psychology at the board room level and, in particular, in the board subcommittee charged with the executive remuneration decision, namely the remuneration committee. He has published widely in leading academic journals, both in the UK and in the USA. Foreword When I took over some six years ago as Director of the David Hume Institute my immediate predecessor was Professor Brian Main of Edinburgh University. Brian was very generous with his time and wise counsel as I felt my way into this new position – and subsequently he has kept in close touch with the Institute and frequently provided advice on a range of matters, including access to his excellent network of academic contacts. Also, throughout the last few years, we have been strongly supported by the Economic and Social Research Council. The ESRC find the Institute to be a valuable partner in helping to disseminate research findings to a broad Scottish audience. We are most grateful to them for providing funds for a number of our seminars and publications. In view of these links with both Brian Main and the ESRC I was delighted, as were our Trustees, when asked to arrange a seminar for Brian to present the results of his latest research, funded by the ESRC. We must acknowledge that this funding included an allocation for dissemination. Therefore the seminar on 1 st June 2011 and this paper are both supported by the ESRC. The research examined trends in executive pay, primarily based upon an examination of pay for CEOs of FTSE-350 companies for the past 15 years. This paper provides a very accessible overview of Brian’s findings. One key, and by no means unexpected, finding is that ‘directors of large UK companies (as represented here by CEOs) are now paid at levels markedly higher than enjoyed by the counterparts in earlier times … during a period in which the top rate of personal taxation has fallen’. Brian then sets this finding in the context of changes in corporate governance over an extended period; and also examines trends towards greater emphasis on payment by results – in a variety of forms. He carefully considers the role of Remuneration Committees, noting the importance of recommendations in the Cadbury Report and also that such committees added ‘legitimacy to those making the pay decision – through their being constituted in a transparent remuneration committee.’ However, extracts from a host of interviews that Brian Main has conducted over the years make clear that being on a Remco is no easy option and further that due to a ‘prisoner’s dilemma’ type situation these committees have tended to err on the side of generosity and edge pay for CEOs towards an ever rising top quartile level! If increasing relative pay levels for CEOs are due to some combination of increased emphasis on shareholder value, the move towards performance related pay and institutional change then what is the best way forward to better relate pay to long-term and sustainable performance? In this paper Brian Main suggests a move towards ‘career shares’, with a requirement that shares from option schemes and the like are not cashed in at some early date by a departing CEO but retained for an extended period post exit – perhaps as long as four years. This would doubtless lead to complaints that share values would be influenced over this period by the performance of the CEOs successors, but why not? Should it not be a major part of a CEO role to look to the longer term for the company, rather than just maximising performance during his or her tenure and then grabbing the rewards and departing? Certainly Professor Main’s paper provides ample scope for debate about pay levels, forms of CEO pay, governance systems and the optimum way forward. This paper represents an excellent combination of an important data set well used by an accomplished academic expert in his field and real suggestions for a way forward in an area of interest to many. The Institute is delighted to be publishing the paper and hosting the seminar but as ever I must close by noting that as a charitable body the Institute has no views on the subject. We simply wish to inform constructive and sceptical debate. Jeremy Peat, Director The David Hume Institute Executive Pay – a career perspective. 1. Introduction This paper argues that the rise in directors’ remuneration in the UK over recent years has been, to a large extent, an unintended consequence of institutional change in the governance arrangements of UK companies. The increase in disclosure regarding the detail of what directors are paid and the adoption of transparent processes by which directors’ remuneration is determined have combined to produce an outcome whereby the top management teams of large publicly held companies are able to command an ever increasing portion of the quasi- rent (surplus after running costs) earned by those companies. It is also true that a shift in shareholder attitudes has brought about an increased emphasis on shareholder value which, in turn, has encouraged the uptake of payment-by-results arrangements for the remuneration of directors. These have made the reward stream more ‘risky’ as far as the individual director is concerned and, in recognition of this and to compensate for risk aversion, the actuarial value of remuneration has increased. In a more general setting, runaway labour costs would be expected to be held in check by competitive forces in the product market or, in the face of diminishing profitability, by the market for corporate control, whereby underperforming companies are vulnerable to takeover. But while remuneration payouts to directors are large by many measures, they do not present a significant issue for the UK’s larger companies. For reasons explored below, the upward pressure on directors’ remuneration can be expected to continue. Some of the less desirable features of this trend (pay without performance, etc.) could in part, be remedied by a move to Career Shares – long term incentives which cannot be cashed out on vesting but must be held until some considerable time after the director has demitted office. The following section of the paper attempts to flesh out this argument, starting with an examination of Chief Executive Officer (CEO) pay trends in the FTSE-350. 2. Remuneration of directors The remuneration of those who run large widely owned companies has long been an issue of concern. Perhaps most pithily put by Galbraith (1974): “The salary of the chief executive of the large corporation is not a market reward for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself.’ Adam Smith had long before voiced similar concerns (Smith, 1776, p264), and the area has recently become the focus of considerable academic research concerning managerial power and optimal contracting (Frydman and Jenter, 2010). As is well known, director remuneration has risen markedly in the UK over recent years. Using data taken from Manifest and focusing on the CEOs of FTSE350 companies, Charts 1 through 4 offer various measures of this increase (all in £2009). These also serve as a reminder that our choice of summary measure (e.g., mean versus median) can very much affect how things appear. 1 The narrowly based measure of remuneration (total cash compensation, TCC, which is essentially salary plus annual cash bonus) can be seen to have clearly increased, but a more dramatic increase occurs when one also includes the components of long term incentive, such as executive share options and performance share plans to form total direct compensation (TDC). The concept of CEO pay is difficult to measure unambiguously. In Chart 1, for example, the average value at the time of award is used 1. For any given CEO, this may over value the eventual worth of the share options and performance shares involved.